Demandable Debt as a Means of Payment: Banknotes versus Checks

We examine the question of whether transactable forms of privately issued, demandable debt are better used as "banknotes" or "checks." The distinction between the two is that a check must be redeemed by the issuing bank with each use, whereas a banknote can circulate. We find that the answer to the question depends critically on the cost of early redemption. If this cost is small, banknotes will not circulate, so the question is moot. If this cost is large, incentive problems will prevent the issue of banknotes. For intermediate values of the early redemption cost, the option of early redemption limits the bank's risk-taking behavior, so that banknotes will be preferred over checks.

JEL classification: E42, G21, N11

Key words: payments, money, banknotes, checks

The authors thank John Bryant, Jerry Dwyer, Ellis Tallman, and workshop participants at the Federal Reserve Bank of Atlanta for helpful discussions and comments. The views expressed here are those of the authors and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. Any remaining errors are the authors' responsibility.